Going for Gold (Again)

Could a return to hard money save the dollar?

By Robert P. Murphy

Conservatives and libertarians often lament President Franklin Roosevelt’s decision in 1933 to confiscate Americans’ monetary gold, a move that killed the classical gold standard. In 1971, Richard Nixon abolished even the diluted gold exchange standard of Bretton Woods and totally severed the dollar’s tie to the precious metal. The world economy has since rested on a foundation of fiat paper money.

What, if anything, have we lost as a result? And could we return to the golden age even if we wanted to?

The supreme virtue of the gold standard was that it restrained the power of the government to debase the currency. Before FDR’s 1933 order, the U.S. was obligated to redeem paper dollars for physical gold. In other words, the dollar was pegged to gold at a fixed rate.

In practice, this put a serious constraint on those who controlled the U.S. printing presses. Other things being equal, if the government—or the Federal Reserve, after 1913—printed more currency, the prices of goods and services quoted in dollars went up. On the other hand, with a fixed number of dollars in existence, there would be a tendency for the prices of goods and services to fall gently in a healthy economy that produced more output over time. As a loose rule of thumb, on a strict gold standard the Fed could only print more dollars as miners brought more physical gold to the surface.

The gold standard offered automatic feedback to restrain excessive inflation of the money supply. If Fed officials started running the printing presses too heavily—flooding the world with new dollars—this would put upward pressure on the market price of gold. If, say, gold began trading at $21.67 per ounce in the open market, and the officially pegged price of gold was $20.67, speculators would short the dollar. They would redeem dollars for gold, then they would sell that gold on the world market, and reap profits of $1 per ounce.

With speculators “attacking” the dollar in this fashion, government gold reserves would soon be depleted, as the Fed effectively had to buy back the excess dollars from speculators. In order to reassure investors that the dollar was still as good as gold, the Fed would be compelled to stop printing money and wait for the dollar to strengthen against the metal before attempting any more inflationary policies.

The gold standard was not perfect. It allowed the Fed to foster a massive asset bubble in the late 1920s, which ushered in the Great Depression as Herbert Hoover foolishly implemented a New Deal-lite to combat the financial crash. Even so, the gold standard prevented runaway inflation of the kind that destroyed interwar Germany and, in our times, Zimbabwe. By providing a solid anchor for the paper currency, the gold standard gave investors, firms, and households confidence in the long-run purchasing power of their monetary unit.

Ludwig von Mises went so far as to liken the gold standard to a bill of rights or constitution. In his view, it prevented the government from diluting the value of the currency to achieve its spending objectives.

Practically speaking, it would be straightforward to put the U.S. back on a gold standard. Fed Chairman Bernanke can do whatever he wants so long as he argues that it will “help the economy.” This includes not only making public proclamations of “quantitative easing,” but also giving behind-the-scenes bailouts worth several trillion dollars to private institutions, including foreign banks.

It would be quite simple for Bernanke to announce at a news conference something like the following:

Starting on January 2, 2012, the Federal Reserve will stop targeting interest rates. Instead, we will use our open market operations to keep the price of gold within a narrow range centered on $2,000 per ounce. To convince investors that we will have the ability to maintain the new peg, starting immediately the Fed will begin selling off its mortgage-backed securities and using the proceeds to accumulate gold. Furthermore, we will allow outside auditors to inspect our holdings of gold every 6 months, so the world will have no doubt that we can maintain our commitment to a stable dollar-price of gold.

After the announcement, Bernanke and his colleagues would figure out whether they had chosen a realistic exchange rate. If the gold price went up to, say, $2,400 per ounce, the Fed would have to remove dollars from the economy, by selling off assets, such as the Fed’s enormous holdings of U.S. government debt—and then, crucially, not buying anything else with the proceeds. This tightening of monetary policy is exactly what the Fed currently does when it wants to hike interest rates. The difference would be that the Fed’s target variable wouldn’t be the federal funds interest rate, but rather the price of gold.

On the other hand, Bernanke might observe that his announcement provided a flood of relief to investors who thought that successive rounds of “quantitative easing” would destroy the dollar. They might sharply reduce their gold holdings and rush back to more conventional assets. This would lead to a fall in the price of gold. In that case, Bernanke could begin writing checks on thin air—just as he currently does—to accumulate more physical gold. He would stop when the price had been pushed back up to the target of $2,000.

The chances of Bernanke following this path are nil. But even if he were willing to do so, should he?

Critics often argue that in a financial panic people rush to gold as the safest of assets. With a floating dollar-price of gold, this shows up as skyrocketing prices for goods. But what if the dollar-price of gold had been fixed? Then the worldwide rush into gold would require massive price deflation for everything else, as measured in dollars. Wouldn’t that have been disastrous?

There are three responses to this. First, part of the reason for skyrocketing gold prices has been investor fears that Bernanke will cripple the dollar with his inflationary schemes. If people were convinced that the currency would always be “as good as gold,” there would have been no reason to dump dollar-denominated assets in favor of gold.

Second, Austrian Business Cycle theory indicates that the reason for our financial panic was the credit expansion undertaken by Greenspan, which fueled the housing bubble. Although booms and busts are still possible under a gold standard, they are kept under tighter control.

Third, a market economy can handle falling prices just fine. The depression of 1920-1921 saw a much sharper fall in prices than any one-year stretch of the Great Depression. The difference was that in the early 1930s Herbert Hoover didn’t allow wages to fall, thus making labor artificially expensive. By the same token, the U.S. economy would have recovered from the collapsing stock market and real estate bubbles long ago had the government and Fed stood back and let nature run its course.

The true danger to economies is a printing press run rampant, not the gold standard.

Robert P. Murphy is an economist with the Institute for Energy Research.

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12 Responses to Going for Gold (Again)

Mr.Murphy’s essay is spot on,but about 80 years too late. The Socialist Welfare/warfare state has so bankrupted America that any chance of meaningful monetary reform is out of the question. There are just too many non producing/net tax consumers in America today. If we had real money(gold & silver) or paper money backed 100% by gold or silver it would be evident to anyone that government,directly or indirectly,is taking about 75% of Americas GDP to support,on all levels,the State. If you couldn’t print or borrow or tax anymore you would have to totally close down most of government and their redistribution programs for lack of funding. The troops would have to come home. The New World Odor bankers would be put out of business. Etc.etc. America would have no choice but to choose liberty in order to survive and prosper.Socialism/Fascism is dishonest government. And,as the old saying goes, “You can’t have honest government with dishonest money.”

Let nature take its course, eh? Milton Friedman had the Austrians’s number:

I think the Austrian business-cycle theory has done the world a great deal of harm. If you go back to the 1930s, which is a key point, here you had the Austrians sitting in London, Hayek and Lionel Robbins, and saying you just have to let the bottom drop out of the world. You’ve just got to let it cure itself. You can’t do anything about it. You will only make it worse.http://economistsview.typepad.com/economistsview/2006/01/milton_friedman.html

beowulf, here’s an expert on the history of banking and money, Larry White, on this topic:

“Contrary to some accounts, the Hayek-Robbins (“Austrian”) theory of the business cycle did not prescribe a monetary policy of “liquidationism” in the sense of passive indifference to sharp deflation during the early years of the Great Depression. There is no evidence that Hayek or Robbins influenced any “liquidationist” in the Hoover administration or the Federal Reserve System. Federal Reserve policy during the Great Depression was instead influenced by the real bills doctrine, which (despite some apparent similarities) was diametrically opposed in key respects to Hayek’s norms for central bank policy.”

The Chicago School with Milton Friedman? Well how many former communists turned conservatives does it take to discredit a school? (the Weekly Standard; Rino/neo-con rag) Bill Kristol’s dad, James Burnham and more.

It took decades to discredit Keynes, will it take the ruin of the US before the former communist filled group called the Chicago School is seen for the statists they are. Let us hope not!

The Austrian School is the only one left standing, and the Chicago School is around to steal supporters away from true free enterprise school to the colors of statism and oligopoly in still yet another form. The Fed is the Chicago Schools puppy and they never speak against the UN, you need not any more proof of their real goals, Rinos and Neo-cons are the same and statism is what they want. and

$2000 per ounce? if we returned to the gold standard the peg would need to be more like $7500 per ounce because the U.S. Gov’t. only has about 8200 metric tonnes of gold and the monetary base is like 2 trillion dollars. the other problem that you did not address is that under the classic gold standard trade deficits are settled in gold. this means that with our current trade imbalance our reserves would be drained rather quickly and our dollar would become worthless very fast. think Weimar, think Zimbabwee. before we ever return to the gold standard, i agree that it is the only real money, we first have to get energy independent. whether this is done through coal, natural gas, wind, solar et al, i don’t care. energy independence needs to be our first priority. then we need to go economic nationalist like pat has been preaching all of these years and bring back as much manufacturing as possible. once we have done these two things and we are no longer running a trade deficit, then and only then could we ever consider another gold standard, which as you outlined in your above article does have redeeming features. just my thoughts.

I’m not a monetarist, more a fan of British economist Wynne Godley (who passed away last year):
“Wynne Godley’s Final Words: Forget the General Theory… Godley was hardly a goldbug, but his system of monetary economics is remarkably consistent with the view of monetary economics embedded in the U.S. Constitution….http://www.dailyspeculations.com/wordpress/?p=4953

“The global financial crisis came as a startling surprise to most academic economists. The Cambridge economist Wynne Godley, who died last month, was an exception. Prof Godley brilliantly anticipated the severity of the US economic collapse with its ballooning fiscal deficits and high unemployment rates… The core of his approach was relatively simple. He divided the world into three sectors – the government, private and foreign sectors – and looked at how money flowed between them…”http://www.ft.com/cms/s/0/a7df74f6-7002-11df-8698-00144feabdc0.html